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What is an Annuity?

Senior Couple Walking In Park TogetherAnnuities are insurance products guaranteeing a regular monthly income for the policy holder, called the “annuitant.”

Annuities were designed to provide a steady income during retirement. They are insurance that you won’t outlive your money. Many seniors use annuities as a supplement to Social Security benefits which cover only a portion of their pre-retirement income.

Annuities are sold by life insurance and investment companies. When you make a payment, the company takes its fee and invests the rest. It then makes payouts to you at regular intervals. The size of your payouts are determined by several factors including your life expectancy and the length of your payout period. Your payout period could be certain number of years or as long as you live, depending on the annuity you purchased.

There are two basic types of annuities.

  1. Immediate Annuity – You make one upfront payment and receive regular payouts right away.
  2. Deferred annuity – You pay premiums over time and receive payouts when you retire.

Within these two types of annuities, there are:

  • Fixed annuities – The payouts are “fixed” i.e. the amount does not change.
  • Variable annuities – The amount of payouts vary with the investment success of the annuity fund. If it does well, your payments are higher. If it does poorly, your payments are smaller.
  • Combinations of fixed and variable.

Annuities have been criticized:

  • Once invested, your money is illiquid. You can’t touch it for a period of time, called the “surrender period,” without paying a “surrender fee.” Surrender periods can last from 2 to 10 or more years and the fees can start at 10%.
  • With a fixed annuity, if you die shortly after you buy, you lose your investment.
  • They can be expensive. Variable annuities especially have optional riders and features that add to the cost. According to Consumer Reports*, variable annuities benefit the insurance agents, who receive healthy commissions, more than the annuitants.

Should you or your parent invest in an annuity? If so, which type? Annuities, with all their variations, are confusing. Do your research before investing.  If you need help, bring your questions to a fee-only investment advisor who does not sell annuities.

 

*”Safe or Sorry? Some Truths about Annuities,” Consumer Reports Money Advisor, June 2013.

4 Comments

  • Tammy says:

    Finally!!!! Someone can explain what an Annuity is! Thank you!

  • Robyn,
    Maybe a slight change to the wording. An immediate annuity is generally a fixed monthly payment for life that can end at death or pay for a period certain, i.e. 10 or 20 years. And yes there is nothing left for a beneficiary.
    I generally think of a fixed annuity as being similar to a CD, i.e. five years at 3%. At the end of five years you can buy a new annuity or cash out but most importantly the money is not gone. The owner or a beneficiary still owns the asset. Generally I stay away from variable annuities for a lot of reasons. While the tax benefits are touted because gains are deferred. What is often glossed over by the sales rep is that when you do sell the gains are taxed as income not the lower capital gains rate, you do not get a step up in basis at death (which can cost your heirs), of course the extra M&E fees that will be a drag on performance and the penalties from the insurance company and possibly the government if you get out early.

    • Robyn says:

      Thank you, Don, for the clarifications and the additional information on variable annuities. Your response underscores the need for people interested in annuities to get professional neutral help to sort out the options.